Invest in Stocks by Trading Sell to Open Put Options

Many investors feel uneasy when the stock market starts heading down, and if the trend continues, they start to feel outright panic. Suddenly, people want to sell off their shares quickly to avoid any further drops in stock prices and the resulting hit to their portfolio's value. As an options trader, you can take advantage of this down-market volatility to help investors curtail their losses while also earning a potential profit for yourself.

One of many options trading strategies, selling open put options could, if executed under the right market conditions, generate a high profit by engaging in transactions that you might have done anyway to capitalize on lower stock prices. Although the market offers no guarantees, this strategy could reward you with some profitable returns on unleveraged equity in an extremely volatile market. If you're a seasoned investor, this process allows you to leverage the knowledge you’ve already acquired about various businesses through your years of studying various annual reports, 10-Ks, and other SEC filings.

For Comparison: A Regular Stock Buy

Let's say that at some point in the past, you had wanted to purchase Tiffany & Co. shares because they have great brand recognition, and they operate using a fairly simple business model. However, you weren't sure how to proceed since the current market was experiencing high volatility and you had seen falling stock prices over an extended time period.

For example, as of the close of markets on October 14, 2008, shares of Tiffany & Co. were selling at $29.09 each, down from a high of $57.32 prior to the crash on Wall Street. Investors were panicked that the retail environment was going to fall apart and that high-end jewelry was going to be one of the first things to go because consumers weren’t going to buy expensive watches, diamond rings, and housewares when they couldn't even pay their mortgage.

Assume you had long wanted to own stock in Tiffany & Co. and had been waiting for just such an opportunity. In a persistent down market, the stock could very well fall another 20, 30, 501 percent or more, but you want to profit from your ownership of Tiffany's stock for the next 10 to 20 years. There could be a way to take advantage of the current situation without actually buying the stock, while also generating some nice returns for your portfolio.

In one scenario, you could just buy the shares outright, pay cash, and let them sit in your account with dividends reinvesting. Over time, according to 200 years of history on average stock market returns, you should experience a comparable rate of return to the performance of the underlying business. Thus, if you wanted to buy 1,000 shares of Tiffany's stock, you would take $29,090 of your own money plus $10 for a commission, and use the $29,100 to buy the stock at the October 14, 2008, market price of $29.09 used for our example.

An Alternative Strategy: Sell Open Put Options on Tiffany & Co.

A more interesting, and perhaps more profitable, scenario using an options strategy can also put your capital to work. Using a special type of stock option, you can create something akin to writing and selling an “insurance policy" for other investors who are panicked about a potential crash in Tiffany & Co.'s stock price.

One type of options called put options, gives the option buyer the right to "put" the stock to the option seller for a predetermined price, typically a higher price than the current market price, good up until a predetermined date. "Sell open" means that you are selling the put options short. To illustrate the "short" concept, if you sell stock short this means you borrow it from your broker and sell it to another investor without owning it. For the strategy to work, you must sell it at a higher price, and then buy the stock at a later time, at a lower price from your broker and keep the profit, assuming the market goes down.

Selling put options open, or short works exactly the same way.

The buyer of the options is never obligated to exercise his right to sell their stock, but when the stock price keeps dropping, the option provides the investor the ability to sell at a set price. This protects investors by letting them get out of their stock position before it loses too much value.

For example, say an investor was willing to pay for an “insurance premium" of $5.80 per share if you, the option seller, agrees to buy his Tiffany stock from him if the price falls to $20.00 per share. You would create this insurance policy by selling, or writing, a put option contract that covers 100 shares of Tiffany & Co. stock. By writing this contract, you would agree to sell another investor the right to force you to buy his Tiffany shares at $20.00 each, any time he chooses between now and the close of trading on the day in which you've chosen for this put option to expire.

In exchange for writing this "insurance policy” that protects the investor from a large drop in the price of the jewelry store shares, he pays you $5.80 per share. This payment becomes yours forever, whether or not the buyer exercises his contract, or in other words, forces you to buy his stock.

The Scenario Illustrated

Say you took the $29,100 that you would have invested in the stock by buying shares outright and instead agreed to write insurance for another investor or “sell open” some put options on Tiffany & Co. shares with an expiration date of the close of trading on Friday one year from today, at a $20.00 strike price. The strike price represents the price at which the option buyer can force you to buy the stock from him.

You contact your broker and place a trade for 20 put option contracts. Each put option contract represents "insurance” for 100 stock shares, so 20 contracts cover a total of 2,000 shares of Tiffany & Co. stock.

The moment the trade executes, you'll earn $11,600 of cash for your options, minus a broker commission. It’s your money forever and it represents the premium the other investor, or option buyer, paid you to protect him from a drop in Tiffany’s stock price.

If Tiffany's stock price falls below $20 per share between now and the option's one-year expiration date, your put option contracts might require you to purchase 2,000 shares at $20 per share for a total of $40,000. On the upside, you've already received $11,600 in premiums. You can add the $11,600 to the $29,100 cash you were going to invest in Tiffany & Co. common stock, for a total of $40,700. Because of the put options you sold, you have a $40,000 total potential commitment to your put option buyer, minus $11,600 in cash received from him, equaling $28,400 remaining potential capital you'd need to come up with to cover the stock purchase price if the options are exercised.

Since originally, you were to spend $29,100 buying 1,000 shares of Tiffany & Co. stock anyway, you're fine with this outcome.

You immediately take your $40,700 and invest it in United States Treasury Bills or other cash equivalents of comparable quality that generate some low-risk interest income. This cash stays there as a reserve until the put option contracts expire.

In this scenario, the company’s stock stays strong, the buyer never exercises his options and the expiration date comes and goes. The put option contracts expire; they no longer exist. You keep the money the buyer paid you for the "insurance premium" forever, and essentially, in exchange for putting $28,400 aside in Treasury bills for a year, you were paid $11,600 in cash. That’s quite a nice return on your capital for the one-year duration of the put option contracts.

The Strategy Changes If the Buyer Exercises His Puts

In the opposite scenario, say your options buyer gets anxious at Tiffany & Co.'s dropping stock price, exercises his options, and you now have to buy 2,000 shares of Tiffany & Co. stock from him at $20 per share for a total cost of $40,000. Remember, however, that only $28,400 of the money was your original capital because $11,600 came from the premiums that the options buyer paid to you for writing the “insurance.” This means that your effective cost basis on each share becomes only $14.20 ($20 strike - $5.80 premium = $14.20 net cost per share).

Recall that you were originally considering buying 1,000 shares of Tiffany & Co. stock outright at $29.10 per share. Had you done that, you’d now have some large unrealized losses on the stock. Instead, because of the options being exercised, you own 2,000 shares at a net cost of $14.20 per share. Since you wanted the stock anyway, planned on holding it for 10 or 20 years, and would have been in a huge unrealized loss position were it not for the fact that you chose to write the options, you now ended up with the Tiffany & Co.

stock you wanted, at a $14.20 cost basis instead of a $29.10 cost basis.

The Outcome and a Word About Risk

In the highly unlikely event, the company goes bankrupt; you’d lose the same as if you’d bought the stock outright. Barring that outcome, if the buyer exercises his options, you get the stock at a reduced cost basis, and you'll also keep the interest earned while you had the money invested in Treasury Bills. That kind of advantage is very substantial, as even small differences in returns can result in vastly different earnings results over time due to the power of compounding—an investor that gets an extra 3 percent each year, on average, over 50 years could have 300 percent more money than his contemporaries.

While speculative and not without risk, these types of transactions can offer the potential for good returns as market volatility increases.

Speaking of risk, this strategy is not recommended for any but the most seasoned investors. Sellers just learning how to sell options can become intoxicated by the large cash receipts deposited into their account from "insurance premium" payments, not realizing the total amount they need to come up with in the event all of the put options they sold were exercised. With a large enough trading account, you as a trader might have a substantial enough margin cushion to buy the shares anyway, but that could evaporate in the event of another round of widespread market panic.

In that case, you would find yourself getting margin calls, logging in to see your broker had liquidated your stocks at massive losses, and witnessing a huge percentage of your net worth wiped out, with nothing you could do about it.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.